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How Dodd-Frank Undermines Reinsurance and Endangers American Policyholders

By Karl L. Rubinstein

As I discussed in my article of September 28, 20101, Title V of the new Dodd-Frank Bill foreshadows a federal takeover of insurance regulation. When effective next year, it will not only subordinate state insurance laws to international treaties relating to “prudential matters,” it will undermine the efficacy of reinsurance and thereby put American policyholders at risk. In this piece, I’ll focus on reinsurance issues.

Specifically, Title V, Subtitle B, titled “Nonadmitted and Reinsurance Reform Act of 2010.” Section 531 (a) will require state insurance regulators to give financial statement credit for reinsurance if the ceding insurer’s home state does so, even if, for example, the home state’s financial requirements are less effective.2Further, it will subordinate state insurance regulators to the contract terms of reinsurance agreements, even if they violate state laws.

For instance, Section 531 (b) of Dodd-Frank expressly preempts state laws restricting arbitration clauses, state laws mandating particular provisions be contained in reinsurance contracts, and state efforts to enforce a reinsurance contract on terms different than those set forth in the contract, or “otherwise apply the state laws to reinsurance agreements of ceding insurers not domiciled in that state.” These provisions reflect a political bias against state regulation and intent to elevate the international reinsurance industry above state law. A general discussion of the nature and purpose of reinsurance will demonstrate the dangers.

Insurer Surplus Requirements:

Under the insurance codes of the several states, insurers can’t issue policies unless they maintain sufficient capital as “policyholder surplus.” Only assets deemed “admitted assets” (meaning, generally, investment grade assets) may be counted in policyholder surplus. This requirement for high quality capitalization has been crucial to the present superior financial condition of most insurers over most non-insurer financial companies. The dismal failure to regulate asset quality in non-insurance financial companies is a prime cause of the continuing economic crisis. There’s little doubt this historical regulatory failure exists primarily at the federal level.

As to insurance, it’s important to remember other people’s money and welfare is at stake. Unlike the corner grocery store or the local widget factory, risking their owner’s finances, the essential purpose of insurance is to take financial risk off the shoulders of the policyholders and place it upon the insurer. Policyholders pay premiums and insurers are expected to protect these funds by proper investment and business practices.

On the strength of its admitted asset backed policyholder surplus, an insurer assumes risk in return for premium dollars which are to be invested in additional admitted assets. But each policy or other contract sold places strain on the insurer’s policyholder surplus. Eventually, all insurers will run out of available surplus and be forced to stop issuing policies unless they obtain new capital or “lay off” risk through reinsurance.

The business of insurance has long been held to involve the “vital public interest.” Osborn v. Ozlin 310 U.S. 53(1940); California State Auto. Ass’n Inter-Insurance Bureau v. Maloney 341 U.S. 105 (1951). The regulation of insurance is squarely within the police power of the individual states, a police power protected by the Tenth Amendment. All states have long-standing and comprehensive insurance codes to accomplish this.

The Nature and Purpose of Reinsurance:

Reinsurance occurs when one insurer (the assuming company) re-insures (assumes) the liability of the original insurer (the ceding company) that issued the original policies. These arrangements are usually called “treaties,” and the reinsurer receives a portion of the premium commensurate with the amount of risk assumed through the treaty.

Under state law, the ceding company receives a dollar for dollar credit to its surplus for reinsurance. Thus, reinsurance acts as a form of capital permitting the ceding company to continuing issuing policies. Broadly speaking, reinsurance is usually either “surplus” or “quota share.”

Under a surplus treaty the reinsurer assumes liability for losses over a specified amount, such as all losses over the first one million dollars. These treaties can involve many layers and many reinsurers, each relating to a portion of the losses over a specified amount. For instance, Reinsurer A may assume liability for one million in excess of the first million. Reinsurer B may assume liability for the next one million in excess of the first two million, and so on.

Under a quota share treaty the reinsurers share a stated percentage of each layer. For example, five reinsurers might each assume twenty percent of the layer of one million over the first million dollars of losses by the ceding company.

Many reinsurers are non-United States domiciles and these types of treaties (and other more exotic ones) are often mixed together, resulting in a complex web of international liability to individual American citizens who have paid billions in premiums to transfer risk. Frequently, the same reinsurers wind up in multiple layers. Often the policyholders know nothing about these reinsurers. Indeed, under most laws, the policyholders are held not to be in privity of contract with the reinsurers, meaning the policyholders have no direct right to sue them in the event of non-payment.

It is entirely possible for the ceding insurer to lay off all of its liability, in which event the financial welfare of American citizens is entirely in the hands of reinsurers in different states or countries. Plainly, it’s important for each individual state to have the power to protect its citizens and to make adequate laws to be sure the funds are available for claims payments. All state insurance codes contain such protections. But Dodd-Frank torpedoes these state laws.

Dodd Frank Sinks State Law:

Title V, Section 531 (b) provides:

In addition to the application of subsection (a), all laws, regulations, provisions, or other actions of a State that is not the domiciliary State of the ceding insurer, except those with respect to taxes and assessments on insurance companies or insurance income, are (1) preempted to the extent that they [prevent] the assuming reinsurer [from resolving] disputes pursuant to contractual arbitration (2) require that a certain State’s law shall govern the reinsurance contract… (3) attempt to enforce a reinsurance contract on terms different than those set forth in the reinsurance contract…[or otherwise apply] laws of the State to reinsurance agreementsof ceding insurers not domiciled in that State.

Title V, Section 313 (c) (E) and (f)] also permit state law to be preempted by international treaties entered into by the Secretary of the Treasury.

Pertinent to the foregoing, Title II of Dodd-Frank, titled “Orderly Liquidation Authority,” sets out a non-bankruptcy scheme of liquidation for banks and certain non-bank financial companies. Section 313(c) allows the Treasury Secretary to recommend an insurer be liquidated as a non-bank financial company, meaning that the entire state statutory insolvency scheme might be side-stepped.

Why This Is Irresponsible:

The core of “insurance” is the idea that policyholders may rely absolutely upon the efficacy of their policies, whether auto, health, life, surety, or other arrangements. Unless the public can have faith in the system, it cannot survive. Yet who can trust a system of laws and promises that may be rewritten by private reinsurance contracts or undone by the Treasury Secretary who may have his or her eye on international issues instead of policyholder rights?

For example, take the case of offsets between the ceding company and the reinsurer. Many state laws limit the right of such offsets because improper set off undermines state laws elevating policyholder claims over general creditor claims. An offset is a back door preference of the general creditor over the policyholders. Under Dodd-Frank, reinsurance treaties can now load up on contractual provisions that undermine policyholder safety.

Equally significant, states law forbids financial statement credit for reinsurance unless the reinsurance treaty contains certain provisions and unless adequate security is provided to support the reinsurers’ obligations. This security can take several forms including letters of credit that meet certain standards and the deposit of funds into “funds held” accounts. Dodd-Frank would allow reinsurance treaties write around these crucial safeguards and undermine policyholder safety.

The legal and moral rationale for insurance regulation and its preference for policyholders over general creditors and shareholders is a broad subject. In my article, The Legal Standing of an Insurance Insolvency Receiver: When the Shoe Doesn’t Fit,3 I discuss in detail the important differences between an insurance insolvency and a non-insurance insolvency. Among other things, I show the assets of an insolvent insurance company are a trust for the benefit of the policyholders, subject to certain claims with higher priority. But general creditors and shareholders are subordinate to policyholders. Subjecting an insurer to bankruptcy laws or the new Dodd-Frank Title II Orderly Liquidation Process would stand these important concepts on their head. Businesses that operate with other people’s money must elevate these persons’ rights over those of general creditors.

Some commentators have argued that, for the sake of efficiency, insurance companies should be subject to the federal Bankruptcy Code.4But the issue is other people’s money, not efficiency. Under the Bankruptcy Code, secured creditors are preferred over unsecured creditors. But the insurance system can’t function if creditors are permitted to take a security interest in policyholder reserves or to an insurer’s admitted assets. The whole point of reserves is that they be free, clear, and available to pay policyholder claims. To allow policyholder funds to be siphoned off through the endless variety of modern security agreements would destroy the system.

This concept applies equally to banks and savings and loans, in which cases the federal government insures depositor’s claims. But the federal government doesn’t insure insurance policyholder claims. There is a system of state guaranty associations that pay insolvency claims up to certain caps and under certain conditions, but these are funded by the public, either by premium tax offsets or by surcharging all policyholders in a particular state. Dodd-Frank’s provisions also cast a long shadow over these institutions.

I certainly don’t suggest the federal government now insure insurance policies, adding yet more billions of taxpayer money to support private industry. What’s wrong with preserving a system that that mandates adequate reserves which are dedicated to paying policyholder or depositor claims? One could argue that change should go the other way and, instead of bailing out banks for the sake of creditors, the reserves should be walled off from creditors so that they’re available to pay claims or repay deposits as a first priority. Instead of lumping insurers and banking institutions in with businesses not using other people’s money, they should be entirely taken out of a system that prefers secured creditors. Secured creditors are usually sophisticated and able to do comprehensive due diligence. Policyholders aren’t. If a secured creditor doesn’t deem it safe to lend without a security interest in other people’s money, then it’s a bad loan and, as a matter of public policy, shouldn’t be permitted.

Dodd-Frank does have provisions that limit banks and other financial institutions from proprietary investments and which, if competently supported by detailed regulations, could help the system and push banks and other financial companies away from reckless financial activities. How effective would these regulations be if they were subordinated to international treaties or the private contracts of institutional financial companies? But what a silly notion.

Conclusion:

It’s difficult to see any congressional thoughtfulness behind Dodd-Frank’s preemption of policyholder protections and the subordination of state law to international treaties and private contracts. Indeed, one sees fleeting images of smoke-filled rooms. Yet, whether by pointed design or neglect-based collateral damage, Dodd-Frank will seriously obstruct a comprehensive system of insurance regulation and imperil the financial safety of American policyholders.

2A ceding insurer’s home state’s laws should not be permitted to endanger policyholders in other states where the ceding insurer does business. Instead, each state should be permitted to protect its citizens from predatory or loose financial practices of companies doing business in that state. On the one hand, Dodd-Frank expands the surplus lines insurance business, making it easier for companies to cross state lines. On the other, it weakens policyholder protection.

3Connecticut Insurance Law Journal, Vol 10, Number 2, 2003-2004.

4 One such paper is “The Inefficiencies of Exclusion: The Importance of Including Insurance Companies in the Bankruptcy Code. “ Emory Bankruptcy Development Journal Vol 24, 2008.But the police power should not elevate expediency over policyholder safety. See also, Dodd-Frank Title II which exempts the new Orderly Liquidation laws from the Bankruptcy Code, thereby creating a third system of insolvency laws.

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Mr. Rubinstein was chief outside council for insurance commissioners in several of the largest U.S. insurance insolvencies. He also acted as special deputy insurance commissioner and special insurance examiner for several insurance departments. See www.karlrubinstein.com for more detail.